Relative Price Dispersion and Economic Shocks: An Inventory-Adjustment Approach

Abstract

THE ISSUE OF RELATIVE PRICE DISPERSION (RPD) has gained prominence in recent years, as the economy was subject to economic shocks and to high and variable levels of inflation. The concern about the increased RPD was due to its potentially harmful effect on the economy. Recently, Blejer and Leiderman [4] evaluated empirically the effect of RPD on economic activity in the postwar United States and found that increased RPD leads to a decrease in the level of output and to an increase in the rate of unemployment. Israelsen and McDonald [13] showed, in a partial equilibrium context, that when wage changes are firmly linked to the general price level, and labor mobility between markets (or industries) is limited, an increase in RPD may lead to increasing unemployment. Pischer [10] suggested that RPD is not necessarily harmful; but when coupled with unexpected inflation, it may be associated with information confusion, leading to a loss through the misallocation of resources. These concerns have raised the interest in understanding the factors causing and affecting RPD, both theoretically and empirlcally. The prevailing theoretical explanations of the factors affecting RPD are based on two main approaches. C)ne approach is based on misinformation-type models, inspired by Lucas's work [14], where individuals are confused between aggregate shocks and relative, marketspecific ones. Barro [3] and Cukierman and Wachtel [9] have proposed that the greater the vanance of the aggregate shocks, the greater the RPD. Barro [3, pp.